From Dollar to e-SDR

HONG KONG – As the risk of a US-China trade war mounts, creating a geopolitically neutral and fair monetary system has become increasingly urgent. The shift from a unipolar to a multipolar world order has not been particularly orderly. Instead, it has produced a kind of monetary non-system that depends on a debt-driven, dollar-based model that is too pro-cyclical, fragile, and potentially biased to support the management of trade conflict.

At the root of the problem are the structural trade and current-account imbalances that arise from the so-called Triffin dilemma: in order to meet global demand for the US dollar as a reserve currency, the United States must run persistent current-account deficits with the rest of the world. Last year, that deficit reached $474 billion, or 2.4% of US GDP.

To be sure, the guarantee that the US, as the issuer of the dominant international reserve currency, can acquire low-cost funding for its fiscal deficit and national debt amounts to what former French President Valéry Giscard d’Estaing famously called America’s “exorbitant privilege.” But that privilege can erode the country’s fiscal discipline, as it has in recent years, resulting in high federal deficits ($833 billion, or 4.2% of GDP, in 2018) and growing federal debt ($21 trillion, or 104% of GDP, as of March).

The policies favored by US President Donald Trump’s administration exacerbate this tendency. Recent tax cuts and increased military spending have led the International Monetary Fund to estimate that the US international investment position will deteriorate in the coming years, with net liabilities reaching 50% of GDP by 2022.

Moreover, Trump’s threats of trade and currency wars are fueling fears that the US dollar could become a weapon in geopolitical disputes. Such a step would trigger immense volatility throughout the international monetary system, throwing many economies – such as those that link their currencies to the US dollar or hold a large volume of dollar reserves – into crisis.

Of course, the Triffin dilemma can be avoided, and America’s outsize influence over the monetary system reduced. All that is needed is a major reserve currency that is not issued by a national authority. Gold was once supposed to fill this role, but it couldn’t meet demand for global liquidity and a store of value.

A better option is the IMF’s Special Drawing Right (SDR), which the second amendment of the body’s Articles of Agreement asserts should become the world’s “principle reserve asset.” Some – including former People’s Bank of China governor Zhou Xiaochuan and former Colombian finance minister José Antonio Ocampo – have since advocated following through on that plan.

Yet the SDR is not used widely enough to serve as a major international reserve currency. According to a Palais Royal Initiative report, a key way to raise the SDR’s global standing is through “regular allocations of SDRs under appropriate safeguards” or even allocations “in exceptional circumstances.” The report also calls for the IMF to work with the private sector “to explore ways in which the SDR could be more widely used in private transactions.”

A key hurdle for the SDR has always been the geopolitical interests and priorities of the reserve-issuing central banks (not just the US, but also the eurozone, China, Japan, and the United Kingdom). But the advent of cryptocurrencies may offer another way: the private sector can work directly with central banks to create a digital SDR to use as a unit of account and store of value.

Such an “e-SDR” would, in a sense, be the quintessential reserve asset, because it would be fully backed by reserve currencies, in the IMF-determined ratio. The supply of e-SDRs would be completely dependent on market demand.

Of course, to enable a gradual shift from the US dollar to an e-SDR as the dominant international reserve currency, a sufficiently large e-SDR-denominated money market would need to be created. To that end, a politically neutral body, owned by the private sector or central banks, should be established to issue the asset. Participating central banks and asset managers would then have to swap their reserve-currency holdings for e-SDRs.

Once the private sector comes to view the e-SDR as a less volatile unit of account than individual component currencies, asset managers, traders, and investors could begin to price their goods and services, and value their assets and liabilities, accordingly. For example, the Chinese government’s massive Belt and Road Initiative could be conducted in e-SDRs. In the longer term, an international financial center, such as London or Hong Kong, could spearhead experimentation with e-SDRs using blockchain technology, with special swap facilities being created to make the asset more liquid.

Another imperative would be to create an e-SDR-denominated debt market, which would appeal to countries that want to avoid getting caught in the crossfire between reserve-issuing countries. Multinational firms and regional and international financial institutions should provide the needed supply of assets. On the demand side, e-SDR-denominated long-term bank debts could be used by pension funds, insurance companies, and sovereign-wealth funds.

The e-SDR-denominated debt market would even be good for all reserve currencies – except the US dollar – as their weight in determining the asset’s value exceeds their current shares in foreign-exchange markets. In the longer term, the e-SDR’s rise could put added pressure on the US to rein in its spending.

The rise of cryptocurrencies has created a unique opportunity for market forces to spearhead a shift toward a truly neutral reserve asset. With US leadership more unpredictable than ever, it is an opportunity that should not be missed.